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Sainsbury Can Buy Asda. That Doesn’t Mean It Should

J Sainsbury Plc said Saturday it is in advanced talks to combine with Walmart Inc.’s Asda. The risk is that the tieup ends up becoming a sad-sack version of the latter.

There are some merits to this supermarket combination. Sainsbury is focused on the south of England, whereas Asda's stronghold is the north.

The combined group would match or exceed the buying power of Tesco Plc, which has just gobbled up Booker in an effort to become Britain's leader in food and food services.

Asda has a big non-food and clothing business, and this could be combined with operations at Sainsbury, including its Argos home goods division. If so, this would be a mighty force in the general merchandise business, able to rival John Lewis and Amazon.com Inc. And Sainsbury could insert lots of Argos pick-up points into Asda stores.

While the combination will require the scrutiny of the competition authorities, the lack of geographic overlap means the penalties may be less severe to get the transaction cleared.

The landscape has changed since the last big supermarket merger, when Morrison bought Safeway in 2004. The German discounters, Aldi and Lidl, have since taken a combined 12.6 percent of the market.

Consequently the regulator might be a hurdle, but might not necessarily get in the way. After all it waved through Tesco’s 4 billion pound ($5.5 billion) purchase of Booker.

The bigger question is whether such a combination is a wise one. Mike Coupe, chief executive officer of Sainsbury, has done a good job with Argos, which he purchased in 2016 for $1.2 billion. But making this work looks much tricker.

One downside is Asda's real estate. Though it’s mostly freehold, it is primarily made up of big stores --- just the sort that many consumers don't want to shop at any more. Sainsbury has always made a virtue of not being exposed to these sprawling shops.

Also, Asda has been a poor performer for the past few years. New Chief Executive Officer Roger Burnley -- who came from Sainsbury -- is making a difference. And Gadfly has argued that consumers may well be at their nadir.

But Sainsbury will have its work cut out reviving those big stores. And Tesco, whose U.K. business is now being steered by the capable Charles Wilson, is unlikely to take the increased competition lying down.

The same can't be said for Walmart. It has been quietly seeking to offload Asda for the past two years, something Gadfly has argued it should be doing.

Valuing Asda is not straightforward given that it is not listed. But however you cut it, it’s a big deal.

Apply Sainsbury's enterprise value to trailing sales multiple to Asda's 2016 revenue, the most recent available, and Asda is worth just over 5 billion pounds. Use Sainsbury's EV/Ebitda multiple and this rises to over 7 billion pounds, approaching 9 billion pounds on EV/operating profit metrics. As of the end of 2016, the net asset value of Asda's freehold property was just under 7 billion pounds. The average of these points to a valuation of just over 7 billion pounds.

Sainsbury's market value is 5.9 billion pounds. If it paid entirely in stock, it would have to issue Walmart a controlling stake. Neither side will want that. Some cash or debt will have to change hands to keep the seller in a minority.

The parties haven’t agreed to a transaction -- more details will be available on Monday. If they do, then, Wal-Mart deserves credit for reducing its exposure to the U.K and extracting itself from its last outpost in Europe, at a time when Tesco is about to get stronger.

Sainsbury has enjoyed something of a rerating lately as investors have warmed to the Argos deal. But such a large transaction -- and one with so many risks -- is likely to test shareholders' resolve.

After Argos, Coupe is at least applying Sainsbury's core grocery skills to M&A. But without careful handling he risks turning his company into Sadbury.

To contact the authors of this story: Andrea Felsted in London at afelsted@bloomberg.net, Chris Hughes in London at chughes89@bloomberg.net.